Information Gap Revealed on Bond Borrowing
Orange County got a glowing review this summer from Moody’s Financial Services, one of the nation’s leading bond-rating agencies.
The firm praised the county’s “conservative fiscal practices” and took special note of its investment pool, whose “strong investment earnings . . . buoyed” its sizable financial reserves.
Now, of course, that pool is known to be running a paper loss of $1.5 billion--precisely because of its dabbling in some of Wall Street’s most volatile and non-conservative transactions.
Moody’s was hardly alone in missing the problems lurking in Orange County’s portfolio. But its miscue is evidence of what top authorities are calling the key public policy issue brought into focus by the county’s investment debacle: a disturbing lack of information about the complex borrowing being done by thousands of municipalities today.
While the rules for what a corporation must disclose to its investors have been well understood for years, the standards of market disclosure for states, cities, towns, counties and special districts are much fuzzier.
“The municipal bond market has been an unregulated market since its inception,” Jeff Spies, treasurer of St. Petersburg, Fla., and an acknowledged authority on municipal finance, wrote in a recent issue of Treasury Notes, the monthly organ of the Municipal Treasurers Assn.
“When the individual investor buys a municipal bond in the secondary market, there is very little current information on which to base the investment decision,” Spies said. “Also, when the need arises to sell that bond, there is little information on its value in the market.”
In part, this is because municipal bonds are much less actively traded than corporate bonds, for which market prices are almost always available.
But the problem also has arisen because municipalities only recently have been forced by limitations on their taxing power and by rising expenses to look to the investment markets for revenue.
While most states have enacted investment codes that dictate what a local agency may or may not have in its portfolio, “most of these codes were written before the investment markets were as complex as they are today,” said Amy Doppelt, senior director of the public finance department of Fitch Investors Service, another bond-rating house. “So it’s not always clear whether a certain transaction is permitted or not.”
Moreover, the riskiness of the newfangled municipal finance sometimes has nothing to do with where an agency actually put its money. Some of Orange County’s potential losses come from its investments in “derivatives”--complex instruments keyed to the movement of interest rates. Those investments proved to be losers when rates began rising instead of falling, as the pool had bet.
But much of the fund’s money is in what essentially are safe U.S. government bonds and notes. It is the structure of those investment deals--including the fact that the county borrowed almost twice the pool’s worth to try to multiply its gains--that has generated the risk.
Until now, Doppelt said, the question of how a municipality actually invests bond proceeds has not been high on the list of facts that must be disclosed to investors.
That was the case in Orange County.
When Orange County school districts and other public agencies went to the market this summer with more than $1 billion in short-term notes--much of which was to be reinvested in the county pool--the bond-rating services paid scant attention to the condition of the pool itself, though its health may prove to be the single most important factor in the agencies’ ability to pay the bonds’ principal and interest.
Instead, the agencies followed the county’s lead, focusing on such extraneous factors as Orange County’s demographic mix.
For instance, S&P--perhaps; the biggest of the bond-analysis services--assigned high ratings to about $350 million in short-term notes issued this summer. Although “recession has taken its toll,” S&P; noted, “income levels (in the county) are high, with median household effective buying income at 127% of the state level and 144% of the U.S.”
That appraisal reflected the mix of information available in the county’s own prospectuses--documents intended for use by people and institutions contemplating the purchase of the county’s notes and bonds.
In disclosure materials for a $600-million short-term issue in July, the county devoted six pages to such factors as personal income, public school enrollments and population growth--and scarcely a page to the investment pool, where the proceeds of the note sale were to be invested.
Moreover, the discussion of the fund itself seems to have slighted its high--and increasing--risk. While noting the pool’s enviable investment returns for the previous four years, the disclosure statement mentioned the downside only in passing, and then only by noting that the pool’s reverse repurchase agreements--complex transactions that borrowed money for the county to reinvest--”may serve to increase the volatility” of the fund. (Volatility is the rate at which an investment’s value fluctuates, up or down.)
Among the facts that the prospectus did not mention was that by the time of the notes’ issuance, the fund may already have paid more than $300 million in cash to investment bankers to cover declines in its holdings’ value. Also not noted was that those reverse repurchase agreements amounted to more than $12 billion in borrowings, overwhelming the $7.5 billion in cash actually invested by the fund’s participating agencies.
Public officials, such as county treasurers, often exert control over as much or more money than private investment managers, but they are subject to much less regulatory scrutiny.
In California, the offices of the state treasurer and state controller said Monday that they have no jurisdiction over local governments’ investment practices, although officials said the attorney general’s office could step in if a local treasurer clearly exceeded his legal authority.
The lack of oversight leaves investors dependent on reports by private analysts, such as Moody’s, Standard and Poor’s and Fitch, which themselves often are privy to--or make use of--only what information bond issuers want them to have.
Indeed, Orange County’s investment pool has become Exhibit A for the argument that not just the nature of disclosure but its depth is important.
Municipal bond investors interviewed Monday said county officials did nothing to hide the exotic and aggressive nature of their investments.
“If you went to the county, they were thrilled to tell you,” says one institutional investor who avoided buying county notes and wishes to remain unidentified.
But only investors who applied their own sophisticated analysis to the figures provided by the county could have divined the scale of the market risk represented in its portfolio of arcane financing deals.
“I thought I was the only person even worried about this,” said the institutional investor. “The rating agencies continued to cite the pool as a positive credit factor.”
S&P; and Moody’s both have said they are reviewing the ratings of existing Orange County notes and bonds, as well as those of agencies with money in the county investment pool. Neither has yet downgraded any ratings. In a statement issued Monday, Moody’s said it has been “in close contact with county officials” and will meet with them later this week, at which time the firm “expect(s) to discuss the situation in greater detail.”
In recent months the Securities and Exchange Commission and other financial overseers have begun moving toward requiring greater disclosure of investment risks by municipalities issuing bonds and notes.
In an advisory issued last month, the SEC said it would require municipalities to make at least an annual disclosure of the nature of their investments in so-called derivatives and other risky investments.
